The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Act) contains provisions known as the Volcker Rule. The material below summarizes the impact of the Volcker Rule on U.S.-based advisers to and managers of private equity, venture capital and hedge funds.
In addition, McGuireWoods has published a separate item summarizing the impact of the Act on the Investment Advisers Act of 1940, as amended, in relation to U.S.-based advisers to and managers of private funds. Please click here to view that discussion.
Executive Summary
The Act includes provisions known as the Volcker Rule, named after former Fed Chairman Paul Volcker. The Volcker Rule requires that federal banking agencies jointly adopt provisions to prohibit banking entities from investing in or sponsoring hedge funds, venture capital funds, and private equity funds, subject to certain exceptions. These restrictions will not go into effect until a study is conducted and implementing rules are adopted. The full impact and scope of the Volcker provisions will not be evident until the regulations are issued.
The new Financial Stability Oversight Council is required to complete the study by Jan. 21, 2011, then make recommendations regarding the implementation of the Volcker provisions. Within nine months after the study is completed, the appropriate federal banking agencies and the Fed would jointly issue final regulations implementing the Volcker provisions. Then there will be a transition period before the regulations become effective.[1] These Volcker Rule provisions will impact private funds which have banking entities as investors. The following summarizes several of the important ways these provisions may affect those funds.
Action Items
As noted above, a study concerning implementation of the Volcker Rule provisions will be followed by proposed regulations. In this process, there will be an opportunity to comment on these proposals. Managers of private funds may wish to monitor this process, including both the study and the rule making proceedings. A large number of important issues will be dealt with in these proceedings. In the meantime, private fund managers should consider the following steps.
Determine the impact of the Volcker provisions on your investor base. If you do not know already, it might be a good idea to gather information from your investors to determine if any of them are impacted by the Volcker Rule.
If your investor base includes an entity that is covered under the Volcker Rule provisions, that entity’s ability to maintain its investment position in your fund will depend upon the size of that position in relation to the size of your fund, and the aggregate amount of similar investments by that entity. As a result, an investor covered by the Volcker Rule provisions may need to reduce (or even eliminate) its position.
An investor with a Volcker Rule issue could reduce its percentage interest through withdrawal, dilution, and transfer.
The appropriate steps will depend upon the specific factual situation relating to the investor and the fund in question.
An investor may consider partial or complete withdrawal.
You should review the operational documents for your fund to determine the situations in which withdrawal is permitted. Some fund documents permit withdrawal generally (or after an initial no-redemption period); and some funds limit or prohibit withdrawals entirely, except with the consent of the manager. Some fund documents contain provisions which allow an investor to withdraw in the event of specified regulatory issues. The Volcker Rule provisions may trigger such a clause.
Depending upon the size of the investor’s position, withdrawal may be problematic. Particularly in the case of venture capital funds, and private equity funds, the withdrawal of an investor may be inconsistent with a fund structure which is based upon long-term capital commitments. So fund managers affected in this manner may want to consider the possibility of transfers of interests from the banking entity to existing or new investors, rather than withdrawals.
Another way to reduce an investor’s position is through dilution. Issuance of additional ownership interests for either new investors or existing investors (other than the banking entity) or a combination of these actions would have this effect. Another scenario where this issue may arise is in the context of uncalled commitments. Depending on the terms of the operative documents and factual circumstances, a banking entity facing Volcker Rule issues may be reluctant to meet capital calls.
You should also check to see if your fund has any arrangements that might be problematic under Sections 23A or 23B of the Federal Reserve Act, such as loans or guarantees or non-market terms.
Also, if you are planning on starting additional funds or raising additional capital, you should consider the potential impact of the Volcker provisions, immediately and in the long term. Subscription Agreements for new funds should contain questions which identify any investors impacted by the Volcker Rule provisions.
Covered Entities
Banking entities subject to the Volcker provisions include:
- Any insured depository institution (banks and thrifts).
- Any company that controls an insured depository institution.
- Any company treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978.
- Any affiliate or subsidiary of these entities.
A systemically significant non-bank financial company subject to supervision by the Fed that engages in proprietary trading, sponsoring or investing in hedge funds or private equity funds, will be subject to rules establishing enhanced capital standards and quantitative limits on these types of activities. However, these activities will not be prohibited.[2]
Investments in SBICs Permitted
The Volcker provisions do not restrict investments in SBICs.
Private Fund Restrictions
The Volcker Rule, subject to certain exceptions, will prohibit banking entities from sponsoring or investing in hedge funds, venture capital funds, or private equity funds.
Definition of Private Fund
The Volcker Rule provides that the terms “hedge fund” and “private equity fund” both mean an entity that is exempt from registration as an investment company under Sections 3(c)(1) or (7) of the Investment Company Act of 1940, as amended (Investment Company Act). The vast majority of private funds, venture capital funds, and private equity funds are structured to take advantage of one of these two exemptions. So the Volcker Rule has the potential to impact virtually all private funds that have a banking entity investor.
In addition, the implementing provisions can define hedge fund and private equity fund to include other “similar funds.” This clause could be used to expand the universe of private funds subject to the Volcker Rule well beyond those types of funds commonly expected to be impacted. For example, there are various types of specialized investment vehicles which are exempt under other provisions of the Investment Company Act. See the fifth bullet under Open Issues below.
Seed Investments
Subject to the provisions in the next section, a covered entity can provide 100% of the initial equity to a fund if:
- Within one year of the fund’s establishment, the banking entity reduces its ownership to no more than 3% of the total ownership of the fund, through redemption, sale or dilution.
- The one-year limit may be extended for two additional years with Federal Reserve approval.
- The banking entity must “actively seek” to get its seed investment reduced to the 3% limit.
- Any seed investment must be immaterial to the banking entity, as defined by the regulatory agencies.
Sponsoring Permitted
“Sponsoring” means acting as a general partner, managing member, or trustee of a fund; selecting or controlling (or having employees, officers or agents who constitute) a majority of the fund’s directors, trustees or management; or having the same name or variation of the fund’s name. The Volcker Rule specifically allows the organizing and offering of a fund, including sponsorship, as long as the fund and the entity do not share the same name and the following criteria are satisfied:
- The fund is organized and offered only in connection with the provision of bona fide trust fiduciary or investment advisory services and only to customers of such services of the banking entity.
- The banking entity acquires no more than a de minimis investment. A de minimis investment is defined to be no more than 3% of a single fund’s total ownership interest.
- All investments in hedge funds and private equity funds in the aggregate must be “immaterial to the banking entity” to be defined by rule, but cannot be more than 3% of the banking entity’s Tier 1 capital.
- The banking entity will need to comply with the restrictions on affiliate transactions with any fund and sponsors consistent with sections 23A and 23B of the Federal Reserve Act. Section 23A prohibits certain “covered transactions” which generally include loans or guarantees, or purchasing assets or securities. Section 23B requires transactions to be on terms substantially the same as those prevailing for similar transactions with non-affiliated persons or entities. (Prime brokerage services are permitted subject to certain conditions.)
- The banking entity cannot guarantee, assume or insure the obligations or performance of the fund or any fund in which the fund invests.
- The banking entity discloses to prospective and actual investors, in writing, that the fund’s losses are borne solely by investors and not by the banking entity.
No director or employee of the banking entity may have an ownership interest in the fund, unless they directly provide investment advisor services to the fund.
Notwithstanding compliance with these provisions, the regulatory authorities have the power under the Volcker Rule to prohibit activities which would: result in a material conflict of interest between the banking entity and its customers, clients or counterparties; result in material exposure by the banking entity; pose a threat to the soundness of the banking entity; or pose a threat to the financial stability of the United States. In addition, the regulators may impose additional capital and diversification requirements with regard to permitted investments in hedge funds and private funds.
Offshore Investments
The Volcker provisions permit the acquisition or retention of any equity, partnership or other ownership interest in, or the sponsorship of, a hedge fund or private equity fund by a banking entity solely outside of the United States, provided that no ownership interest in such hedge fund or private equity fund is offered for sale or sold to a resident of the United States, and that banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or the states.
Timing
The development of implementing regulations is contemplated within 15 months after enactment. The Volcker regulations would become effective upon the earlier of one year after final implementing regulations are issued and two years after enactment.
There would be a transition period after implementing regulations are effective. Prohibited investments or relationships would need to be eliminated, transferred or restructured within two years after the effective date of final regulations, with up to three potential one-year extensions of this two-year transition period.
There is also a potential extension for illiquid investments. This provision permits the Fed to extend the transition period to the extent necessary to fulfill a contractual commitment that was in effect on May 1 2010, to take or retain an ownership interest in an illiquid fund. Under this provision, the Fed can extend the transition period one year at a time, for up to five years. (It is unclear whether this five-year extension is in place of, or would be in addition to, the three potential one-year extensions.)
Open Issues
A very large number of “open issues” exist concerning the operation of the Volcker provisions dealing with private funds, including:
- Operation of the transition period. For example, will new investments that violate the Volcker rule restrictions be permitted?
- For example, will new investments that violate the Volcker rule restrictions be permitted?
- The criteria for Fed approval for transition period extensions. The Volcker Rule contains a number of time limits for compliance which can be extended with approval from the Fed. It is unclear whether this approval will be subject to demonstrating any particular level of hardship or diligence in trying to obtain compliance, or will be granted automatically upon request.
- The Volcker Rule contains a number of time limits for compliance which can be extended with approval from the Fed. It is unclear whether this approval will be subject to demonstrating any particular level of hardship or diligence in trying to obtain compliance, or will be granted automatically upon request.
- The method of calculating the limits in the case of “parallel funds.” In many fund structures, there are “parallel funds” to accommodate various types of investors. It is unclear whether the de minimis provisions will aggregate parallel funds or treat them as separate funds for the purpose of determining compliance with the de minimis limits.
- In many fund structures, there are “parallel funds” to accommodate various types of investors. It is unclear whether the de minimis provisions will aggregate parallel funds or treat them as separate funds for the purpose of determining compliance with the de minimis limits.
- The ability of covered entities to invest in funds they do not “sponsor.” The Volcker Rule provisions do not explicitly permit investment in private funds where the banking entity does not have an identified role in sponsoring, organizing, or offering the fund. This absence may simply be an oversight which will be fixed in the rulemaking process.
- The Volcker Rule provisions do not explicitly permit investment in private funds where the banking entity does not have an identified role in sponsoring, organizing, or offering the fund. This absence may simply be an oversight which will be fixed in the rulemaking process.
- Specialized investment vehicles. Several types of investment vehicles are exempt from registration under the Investment Company Act under provisions other than Sections 3(c)(1) or 3(c)(7), but which often function in a manner similar to private funds. These investment vehicles include certain types of charitable funds and employees’ securities companies. It is unclear whether the implementing regulations will pick up any of these other types of funds.
- Several types of investment vehicles are exempt from registration under the Investment Company Act under provisions other than Sections 3(c)(1) or 3(c)(7), but which often function in a manner similar to private funds. These investment vehicles include certain types of charitable funds and employees’ securities companies. It is unclear whether the implementing regulations will pick up any of these other types of funds.
The Private Equity Practice at McGuireWoods LLP is dedicated to keeping our clients advised of new legislative and business developments as they occur. If you have any questions regarding these issues, please feel free to contact your primary attorney at McGuireWoods LLP or you may contact the authors.
NOTES:
1. The discussion below focuses on the Volcker provisions dealing with investments in private funds. The Volcker Rule also contains provisions which will result in restrictions on proprietary trading by banking entities. This paper does not deal with these proprietary trading provisions.
2. Certain institutions that function solely in the role of trustee or fiduciary are not subject to the Volcker provisions.